The EDHEC Risk and Asset Management Research Centre has released a working paper examining the common factors behind the failure of hedge funds. The paper, entitled ‘Quantification of Hedge Fund Default Risk’, was written by EDHEC researchers Jean-Ren Giraud, Stphane Daul and Corentin Christory.
The objective of the paper was to provide an initial framework for quantifying the non-financial extreme risk of hedge funds with the aim of factoring it into the portfolio construction phase. The paper examines the statistical properties of hedge fund failures and attempts to identify essential risk factors that can begin to explain why certain funds are more likely to default on their investors and creditors than others.
According to the authors, there are three lessons to be learned from the paper:
1. Within the parameters of the study, hedge fund operational risk cannot be navely diversified without including more than 40 funds, resulting in a possible overdiversification of the financial properties of the funds. As a result, thorough due diligence is an absolute requirement prior to investing. Investors should keep in mind that an increased number of funds also implies less time to investigate each individual fund and the inclusion of funds with lower standards of operations, hence possibly increasing the final likelihood of default of individual funds.
2. The cost and complexity of hedge fund operational due diligence can be significantly reduced by performing an ‘informed’ due diligence process. This ‘informed’ process will take into consideration the relative importance of the main risk factors to hedge funds in general (such as fraud), and the level of complexity/risk of the specific fund and management company under scrutiny, in order to determine the extent of operational review required. Not all factors have been analysed but the authors highlight product complexity (investment style), geography and size as factors that have proven to result in different risk profiles.
3. An ‘informed’ diversification of the operational risk in the portfolio construction phase results in significant differences in the risk-adjusted profiles.